From the course: Financial Accounting Foundations

Unlock this course with a free trial

Join today to access over 25,300 courses taught by industry experts.

Debt ratio

Debt ratio

From the course: Financial Accounting Foundations

Start my 1-month free trial Buy for my team

Debt ratio

“

- The benefit of financial leverage is that using borrowed money allows a company to be larger with the same level of shareholder investment. More borrowed money means more assets. More assets means more sales. More sales means more profits, again, all with the same initial shareholder investment. So more leverage can mean a higher return on equity. This is great for the owners of the company. But too much leverage means that the possibility of loan default and possible bankruptcy is uncomfortably close. This is not great for the company's banks. Imagine three different scenarios involving a company with $100 in assets. Scenario one, low leverage: $99 in owner investment and $1 in borrowed money. Scenario two, middle leverage: $50 in owner investment and $50 in borrowed money. Scenario three, high leverage: $1 in owner investment and $99 in borrowed money. Now, let's say that something bad happens to the assets and they decline in value from 100 to $60. In scenario one, with low…

Contents